The Bank of England’s flagship cheap loans scheme is likely to fall short of
its £80bn target because it is no longer as effective as when it was
launched.

Figures in the Bank’s Quarterly Bulletin show that banks and building societies could be penalised if they used the Funding for Lending Scheme (FLS) and shrank their loan book by more than 3pc.

When the state-backed scheme was launched, the Treasury said it could lower borrowing costs on £80bn of the UK loan stock – driving more and cheaper credit through to households and businesses. According to the Bank’s figures, however, it will now only be effective on about £50bn.

The change is due to a sharp fall in funding costs in the market. When the scheme was first announced in June, the cheapest market rate was 2.7pc. Currently, banks can fund in the market for as little as 1.7pc.

The FLS fees are calculated on a sliding scale from just 0.75pc if banks maintain or increase their stock of loans, to 2pc if they shrink their loan book by 5pc or more. Under the arrangement, banks that contract lending by 4pc or above will be charged at least 1.75pc under the FLS – more than it would cost to issue covered bonds.

Improvements in the markets are likely to hamper the scheme’s take-up, which comes on the heels of its disappointing start. Just six lenders used the scheme in its first two months, and they shrank their lending by £1bn. At that point, the FLS had been tapped for £4bn of cheap funding but the Bank said “more has been drawn since”.

The Bank will claim that lower market rates are proof of the scheme’s success. It said the 1pc fall in market rates since June “probably reflects both the impact of the FLS and other policy measures”. It added: “The FLS will continue to provide a cushion against fluctuations in funding costs, for example if investor concerns about euro-area strains were to intensify again.”

Funding costs have fallen more in the UK than in Europe or the US, suggesting the policy is working. The effect has been clearest in the mortgage market, where there have been the beginnings of a mortgage war.

The Bank said: “There is evidence suggesting that the reduction in bank funding costs is beginning to feed through to the terms and availability of credit. Lenders reported in the third quarter that mortgage availability had increased markedly.”